July 23, 2024


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The SEC Proposes a Revised Definition of “Dealer” Intended to Capture, Among Others, High Frequency Traders a/k/a “Flash Boys” | Patterson Belknap Webb & Tyler LLP

On March 28, 2022, the Securities and Exchange Commission announced proposed changes to Exchange Act Rules that would expand the scope of which market participants the SEC considers to be a “dealer” or “government securities dealer.”[1] Most investors would notice no change in their portfolio management practices.  But for certain high-frequency trading operations, the new rules might lead to substantial changes.

Who is a dealer?

Currently, the Securities Exchange Act of 1934 defines a dealer is “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise.”[2] To avoid capturing every investor, however, the Act also includes an exception for those who buy or sell securities for their own accounts “but not as a part of a regular business.”[3]

The question of exactly who qualifies as a dealer is not always obvious, as, for instance, the occupation of “day trader” has become ubiquitous.  The SEC has developed its analysis over the years to consider factors such as whether the party has a regular clientele, holds itself out as available to buy and sell at a regular place of business, has a regular turnover of inventory, acts as an underwriter, provides liquidity services, or makes a market in a security.[4] Still, as Commissioner Hester Peirce noted, “[d]rawing the line between dealers and other active participants in our markets has long been challenging, and those challenges have only increased as our markets have evolved over the decades.”[5]

Fortunately, the SEC’s new proposed rule has a much narrower focus than individual investors. As mentioned by Chair Gary Gensler in his statement accompanying the proposal, “electronification and the use of algorithmic trading have made transacting in this market faster than ever before,” which has led to “a number of high-profile events in markets with significant participation by” high-frequency traders or HFTs.[6]

Why the focus on HFTs?

To be clear, the SEC rule would not apply solely to HFTs. However, the scope of the rule appears to be crafted to draw large, influential HFTs into the dealer registration requirement.

HFTs first came to the public’s attention following the 2010 “Flash Crash” in which an HFT’s trading algorithm triggered a self-reinforcing wave of selling in the market for eMini S&P500 futures, contracts that are based on projected values of the S&P 500 index. This, in turn, triggered a wave of selling in an exchange-traded fund, SPY, that also tracks that index. As the declines swept across the markets, the Dow Jones Industrial Average was forced down more than 995 points – nearly 9 percent – in the span of approximately four minutes.[7] But the May 2010 Flash Crash was far from the only such event.  A similar event in the market for U.S. Treasury Bonds occurred in 2014,[8] and many other abrupt price declines have occurred in the markets for individual securities, such as a 1.6 percent decline in the stock price of Goldman Sachs Group, Inc. in the span of 0.0004 seconds.[9] 

Michael Lewis’ 2014 book, Flash Boys: A Wall Street Revolt, offered an accessible (if somewhat simplified) description of how HFT operations were able to appear to be posting bids for shares, but could withdraw those bids before investors could accept them. This created the appearance of liquidity in the market, but this liquidity could prove illusory.  As Lewis noted, in times when selling pressure mounted and liquidity was needed, HFT firms could withdraw bids, leaving the market even more prone to abrupt price shocks.

How would the proposed rule work?

The SEC’s proposed rule would include in the definition of “dealer” market participants who engage “in a routine pattern of buying and selling securities that has the effect of providing liquidity to other market participants.” This can include:

  • Routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day;
  • Routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants; or
  • Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interests.[10]

The rule would be limited to firms that control more than $50 million and other rules would apply specifically within the U.S. Treasuries markets.

By requiring market participants – including but not limited to HFTs – who appear to or hold themselves out as providing liquidity to the market to register with the SEC, markets could benefit from increased oversight and regulation. This “would provide regulators with a more comprehensive view of the markets through regulatory oversight and would enhance market stability and investor protection.”[11]

The Commission’s proposed rule is Release No. 34-94524; File No. S7-12-22. Public comments may be submitted until at least May 27, 2022.

[1] SEC Proposes Rules to Include Certain Significant Market Participants as “Dealers” or “Government Securities Dealers”, Securities and Exchange Commission (Mar. 28, 2022) available at https://www.sec.gov/news/press-release/2022-54.

[2] 15 U.S.C. § 78c(a)(5)(A).

[3] 15 U.S.C. § 78c(a)(5)(B).

[4] See, e.g., Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, Release No. 34-47364, available at https://www.sec.gov/rules/final/34-47364.htm#P121_23971.

[5] Statement on Proposal to Further Define “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer,” S.E.C. Commissioner H. Peirce (Mar. 28, 2022) available at https://www.sec.gov/news/statement/peirce-statement-proposal-further-define-dealer-032822.

[6] Statement on the Further Definition of a Dealer-Trader, S.E.C. Chair G. Gensler (Mar. 28, 2022) available at https://www.sec.gov/news/statement/gensler-statement-further-definition-dealer-trader-032822.

[7] See, e.g., Findings Regarding the Market Events of May 6, 2010, Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, S.E.C. and C.F.T.C. (Sept. 30, 2010) available at https://www.sec.gov/files/marketevents-report.pdf.  For a more technical discussion, see Nanex Flash Crash Summary Report, Nanex (Sept. 27, 2010) and related reports, available at http://www.nanex.net/FlashCrashFinal/FlashCrashSummary.html.

[8] Levine, Z., et al., The October 2014 United States Treasury bond flash crash and the contributory effect of mini flash crashes, PloS One (Nov. 1, 2017) available at doi:10.1371/journal.pone.0186688.

[9] See Golub, A., et al., High Frequency Trading and Mini Flash Crashes, SSRN Electronic J. (Nov. 2012) at 3 (Fig. 1) available at DOI:10.2139/ssrn.2182097.

[10] S.E.C., Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer, Release No. 34-94524; File No. S7-12-22 (Mar. 28, 2022).